CHAPTER 7 ACCEPTING THE ENGAGEMENT AND PLANNING THE AUDIT Fall 2007 u Client Acceptance and Retention u Planning the Audit u Obtaining an Understanding.
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CHAPTER 7 ACCEPTING THE ENGAGEMENT AND PLANNING THE AUDIT Fall 2007 u Client Acceptance and Retention u Planning the Audit u Obtaining an Understanding of the Client’s Business and Industry
Overview of a Financial Statement Audit 4 Phases of an Audit 1. Client Acceptance and Retention 2. Planning the Audit 3. Performing Audit Tests (field work) 4. Reporting the Findings
Client Acceptance: Guidance Authoritative Guidance –SAS’s (AICPA) –Quality Control Standards (AICPA) –Court cases –SOX if public company (available at www.pcaobus.org)
Client Acceptance: Steps This is a two way street Clients solicit proposals Auditors investigate situation considering their own business risk 1.Evaluate the integrity of management 2.Identify special circumstances and unusual risks 3.Assess competence to perform audit 4.Evaluate independence 5.Decision to accept or decline 6.Prepare engagement letter for accepted clients
Client Acceptance: Management Integrity Required communication with the predecessor auditor Make inquiries of other third parties Review previous experience with existing clients
Client Acceptance: Identify Special Circumstances & Unusual Risks Focus on the auditor’s business risks Identify intended f/s users Assess prospective client’s legal and financial stability Identify scope limitations Evaluate the entity’s financial reporting systems and auditability
Client Acceptance: Assess Competence to Perform the Audit Services desired Identify the audit team Need for consultation and use of specialists
Client Acceptance: Evaluating Independence & Decision to Accept Evaluate whether there are any circumstance that would impair independence –Other services performed by the firm –Engagement team Put it all together and decide if you want this client! And if you do….
Client Acceptance: Prepare Engagement Letter Identify entity and F/S to be audited Objective and purpose of the audit Reference to professional standards to be used Nature and scope of audit and responsibilities Audit may not detect all material irregularities Management is responsible for F/S & I/C Timetable and client support Management asked for written representations Any auxiliary services to be provided Basis for fees and billing arrangements Request for client signature and return of letter
Audit Planning and Risk Assessment 1.Identify relevant f/s objectives 2.Obtain understanding of entity & its environment 3.Make preliminary judgments about materiality 4.Perform analytical procedures 5.Consider audit risk including fraud risk 6.Develop preliminary audit strategies 7.Obtain understanding of I/C
Understanding the Entity and Its Environment Fundamental assumption: Client’s business risks correlated with the auditor’s audit risk. Basic Idea: –Think about business & industry in context of larger economic situation. Where “problems” likely for the business, the f/s are most likely to be misstated. –Where the f/s most likely to be misstated, we need to do the most audit work. Pervasive vs. account specific factors
The Entity and Its Environment: Factors to Consider Difficult Economic Times –Reductions in capital spending –Restructurings, inventory liquidations, write-offs –Downward pressure on earnings –Liquidity issues Pressures to Perform –Analysts, creditors and shareholders focus on short-term performance –Earnings targets, debt covenants, performance based compensation
The Entity and Its Environment: Factors to Consider Complexity and Sophistication of Business Structures and Transactions –Goal is to meet specific reporting and economic objective –Purchase/sales of assets, derivative transactions, SPE’s etc to transfer risk of ownership Complex and Voluminous Standards –Complex accounting rules follow complex transactions –Opens up opportunities to “get around rules”